7th anniversary of the beginning of a painful lesson

Commentary: What the popping of the Internet bubble should have taught us

ANNANDALE, Va. (MarketWatch) -- This weekend marks a dubious anniversary: the 7th anniversary of the beginning of the end of the Internet bubble.

It was on March 10, 2000, that the Nasdaq Composite index
COMP, +0.65%
closed at its all-time high of 5,048.62. By the time all the air in the Internet bubble had been let out, some 2-1/2 years later on Oct.9, 2002, that benchmark stood at 1,114.11 some 78% lower than where it stood at the top.

That drop was so huge, in fact, that even with the Nasdaq's 114% gain since that bear-market low, it still stands today nearly 53% lower than where it stood prior to the bubble bursting.

No wonder so few are inclined to take note of this anniversary.

I nevertheless think it is important, if for no other reason than to ask this question: How unusual is it for a major market benchmark to be this far below its previous high, this far after the bear market has ended?

The answer turns out to be fairly complex. In general, I found when reviewing the historical record, the speed with which a market index recovered its bear-market losses is a function of how diversified it is. Dividends are another crucial factor.

Neither of these factors supports a speedy recovery in the Nasdaq. Over-the-counter stocks typically pay few or no dividends, of course. And the index is not particularly diversified. As a cap-weighted index, it is dominated by a relatively few of the largest-cap over-the-counter stocks. This was particularly the case in March 2000, when Cisco Systems, Inc.
CSCO, +0.57%
was the single largest-cap stock of any U.S. publicly-traded company.

So it is not surprising that the Nasdaq is still so far behind its March 2000 high.

A brief review of previous bear markets will help provide some helpful context. Consider the 1973-1974 bear market, which - depending on the index you looked at - has been the worst bear market since the Depression. If you focus on the Dow Jones Industrial Average
DJIA, +0.45%
it took nearly eight years for the subsequent bull market to fully recover from that bear market's losses: It wasn't until Nov. 3, 1982, that the Dow surpassed its Jan. 11, 1973, high - almost eight years after the bear market low set on Dec. 6, 1974.

But this exaggerates how long it really took, since the Dow numbers I just cited don't include dividends and the Dow includes just 30 stocks. If you instead look at the Dow Jones Wilshire 5000 index
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which incorporates all publicly-traded U.S. stocks, and if you also include dividends, the recovery took just two years: By December 1976, the total-return Wilshire 5000 was higher than where it was in early 1973.

The recovery from the 2000-2002 bear market took just four years. It was on Sept. 28, 2006, that the dividend-adjusted Dow Jones Wilshire 5000 index surpassed its March 2000 high, almost exactly four years following the bear market low set on Oct. 9, 2002. See Sept. 28, 2006, column

Recovery time exaggerated

What about the Great Depression? The recovery from that bear market would certainly appear to have taken far longer than just two or four years. But, once again, the recovery time has been exaggerated.

The reason that most think that the recovery time was so long is because they focus on the Dow. It wasn't until Nov. 23, 1954, that the Dow surpassed its Sept. 3, 1929, high. That was more than 25 years later.

But once again it is worth noting that the Dow does not represent the entire market. It turns out that the particular stocks that were included in the Dow in the 1930s and 1940s performed significantly less well than the overall market.

Perhaps the most celebrated example of how unrepresentative the Dow was then: The now-infamous decision Dow Jones & Co.
DJ
made in 1939 to remove International Business Machines
IBM, +0.46%
from the list of the 30 Dow stocks. (IBM was not added back to the list until decades later.) According to Norman Fosback, editor of Fosback's Fund Forecaster, the DJIA would be more than double its current level if Dow Jones & Co. had not made that decision.

Dividends also played a big role in stocks' recovery from the 1929 Crash and subsequent bear market.

Consider the stock series constructed by Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania, and author of the classic book "Stocks for the Long Run". He shows that, for all intents and purposes, stocks on a total-return basis in late 1936 and early 1937 had risen back to their September 1929 high, before entering into another bear market.

This puts the recovery time at a little more than four years from the stock market's July 1932 bottom.

These examples, coupled with the Nasdaq's struggles, point to one overarching investment lesson, in my opinion: The virtues of diversification. Your chances of recovering relatively quickly from a bear market are markedly lower to the extent you become under-diversified.

Education, a wise man once said, is never expensive once attained. Perhaps, if we all truly learn the benefits of diversification because of it, the bursting of the Internet bubble will have been worth it after all.

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